Posts Tagged ‘vertical integration’

Pubs are closing down in the UK at the rate of 29 per week. The total number has fallen from 67,000 in 1982 to approximately 52,000 this year. In response to this decline the government has recently announced some changes to the way the relationship between pub owners and their tenants are regulated.

The ownership of pubs in the UK changed dramatically after a report on the beer market was published by the Monopolies and Mergers Commission (MMC) in 1989. When this investigation took place over 75% of the beer in the UK was produced by the six largest brewing businesses (Bass, Allied Lyons, Grand Metropolitan, Whitbread, Scottish and Newcastle, Courage) which owned over half the pubs. The nature of the relationship between these breweries and the landlords of the pubs they owned caused the greatest concerns.

Some pubs are run as managed houses. In this type of business relationship the person who manages and runs the pub (the publican) is a direct employee of the brewery. However, in many instances this is not the case. Instead they are independent entrepreneurs who enter into a tenancy agreement with the owner of the pub. In other words they rent the pub from the brewery and have some freedom over the way it is run including the setting of prices.

These arrangements have proved to be very controversial because of one particular aspect of many of the tenancy agreements – the exclusive supply contract. Known as the ‘tied lease model’, ‘beer tie’ or ‘wet rent’, it significantly reduces the freedom of publicans to run the business, as they have to purchase almost all their beverages from the brewery that owns the pub.

The MMC report in 1989 concluded that a significant reason for the increasing real price of beer was the market power exerted by the brewers through the tied lease model. It recommended that the number of pubs owned and operated by the brewers should be substantially reduced. Known as the ‘Beer Orders’, the brewers responded by gradually selling off 14,000 pubs. They also eventually sold the breweries to international rivals and companies such as Whitbread and Bass moved into the retail, leisure and hotel sectors. Whitbread currently owns Costa, Brewers Fayre and Premier Inn hotels while Bass, renamed Intercontinental Hotels Groups, owns both Crown Plaza and Holiday Inn hotels.

The beer tie between the pubs and the big national breweries might have disappeared but the tied lease arrangement still exists. Instead of being tied to national brewers, many publicans are tied to either smaller regional breweries, such as Everards and Adnams, or another type of business – the pub company known as ‘pubcos’. Some of the larger pubcos include Enterprise Inns, Punch Taverns, Mitchells&Butlers and JD Weatherspoon. They negotiate deals with the breweries and then supply the beer to their pubs.

In 2014, The British Beer and Pub Association estimated that two-fifths of pubs in the UK were owned by pubcos, while another fifth were owned by regional breweries. In 2013, The Department for Business, Innovation and Skills estimated that 48 per cent of pubs in the UK had landlords who were tied to either a regional brewer or a pub company.

The ownership of pubs may have changed radically over the past 20 years but the tied lease system continues to be extremely controversial. The main argument against the system is that it leads to tied publicans having to pay significantly above free market prices for their beer. The pubcos accept this claim but maintain that, in return for being in a tied lease, the publican pays a lower rent and receives business support services.

a statutory Pubs Code to govern the relationship between the businesses that own the pubs and their tenants;

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a new independent Adjudicator to enforce the code;

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a Market Rent Only (MRO) option.

In October 2015 the government announced some proposals for how the MRO option could be implemented as part of its consultation process with the industry. These include giving the tied publican the right to ask for a rent assessment every five years or whenever the owner of the pub significantly changes the beer prices it charges the tenant. As part of this rent assessment the publican can take the option to switch to an MRO contract. This gives them the freedom to purchase beer from any supplier rather than being tied to those supplied by the owner of the pub.

Enterprise Inns, the largest pubco, operates nearly all of its pubs on the tied lease model. In response to the changes proposed by the Government, the company has announced plans significantly to increase the number of its directly managed pubs from just 16 to 800.

What has happened to the big six national brewers which once dominated the beer industry in the UK?

What factors have caused the decline in the number of pubs?

Using a diagram, illustrate the impact that the market power of the pubcos might have on the prices paid by publicans in a tied lease.

Discuss some of the potential advantages of the tied lease model.

The global brewers and pubcos might create a situation where market power exists in successive stages of the vertical supply chain. Analyse some of the potential implications of this structure and discuss the concept of double marginalisation.

The UK energy industry (electricity and gas) is an oligopoly. There are six large suppliers: the ‘Big Six’. These are British Gas (Centrica, UK), EDF Energy (EDF, France), E.ON UK (E.ON, Germany), npower (RWE, Germany), Scottish Power (Iberdrola, Spain) and SSE (SSE Group, UK). The Big Six supply around 73% of the total UK market and around 90% of the domestic market.

Energy suppliers buy wholesale gas and electricity and sell it to customers. The industry has a considerable degree of vertical integration, with the energy suppliers also being involved in both generation and local distribution (long-distance distribution through the familiar pylons is by National Grid). There is also considerable horizontal integration, with energy suppliers supplying both electricity and gas and offering ‘dual-fuel’ deals, whereby customers get a discount by buying both fuels from the same supplier.

Smaller suppliers have complained about substantial barriers to entry in the industry. In particular, they normally have to buy wholesale from one of the Big Six. Lack of transparency concerning their costs and internal transfer prices by the Big Six has led to suspicions that they are charging more to independent suppliers than to themselves.

Under new regulations announced by Ofgem, the industry regulator, the Big Six will have to post the prices at which they will trade wholesale power two years in advance and must trade fairly with independent suppliers or face financial penalties. In addition, ‘a range of measures will make the annual statements of the large companies more robust, useful and accessible.’ According to the Ofgem Press Release:

From 31 March new rules come into force meaning the six largest suppliers and the largest independent generators will have to trade fairly with independent suppliers in the wholesale market, or face financial penalties. The six largest suppliers will also have to publish the price at which they will trade wholesale power up to two years in advance. These prices must be published daily in two one-hour windows, giving independent suppliers and generators the opportunity and products they need to trade and compete effectively.

But will these measures be enough to break down the barriers to entry in the industry and make the market genuinely competitive? The following articles look at the issue.

The energy market is complex and is a prime example of an oligopoly: a few dominant firms in the market and interdependence between the suppliers. Over 95% of the market is supplied by the so-called ‘big six’ and collectively they generate 80% of the country’s electricity. There are two further large generators (Drax Power Limited and GDF Suez Energy UK), meaning the electricity generation is also an oligopoly.

This sector has seen media attention for some years, with criticisms about the high profits made by suppliers, the high prices they charge and the lack of competition. Numerous investigations have taken place by Ofgem, the energy market regulator, and the latest development builds on a simple concept that has been a known problem for decades: barriers to entry. It is very difficult for new firms to enter this market, in particular because of the vertically integrated nature of the big six. Not only are they the suppliers of the energy, but they are also the energy generators. It is therefore very difficult for new suppliers to enter the market and access the energy that is generated.

Ofgem’s new plans will aim to reduce the barriers to entry in the market and thus make it easier for new firms to enter and act as effective competitors. The big six energy generators are vertically integrated companies and thus effectively sell their energy to themselves, whereas other suppliers have to purchase their energy before they can sell it. The regulator’s plans aim to improve transparency by ensuring that wholesale power prices are published two years in advance, thus making it easier for smaller companies to buy energy and then re-sell it. Andrew Wright, the Chief Executive of Ofgem, said:

These reforms give independent suppliers, generators and new entrants to the market, both the visibility of prices, and [the] opportunities to trade, [that] they need to compete with the largest energy suppliers…Almost two million customers are with independent suppliers, and we expect these reforms to help these suppliers and any new entrants to grow.

Although such reforms will reduce the barriers to entry in the market and thus should aim to increase competition and hence benefit consumers, many argue that the reforms don’t go far enough and will have only minor effects on the competitiveness in the market. There are still calls for further reforms in the market and a more in-depth investigation to ensure that consumers are really getting the best deal. The following articles consider this ongoing saga and this highly complex market.

As Elizabeth noted in Fuelling the Political Playing Field, there has been much debate recently about energy prices in the UK. Four of the ‘Big Six’ energy companies have now announced price rises. They average 9.1% – way above the rate of consumer price inflation and even further above the average rate of wage increases. What is more, they are considerably above the rate of increase in wholesale energy prices, which, according to Ofgem, have risen by just 1.7% in the past year.

The bosses of the energy companies have appeared before the House of Commons Energy and Climate Change Select Committee to answer for their large price increases. The energy companies claim that the increases are necessary to cover not only rising wholesale prices, but also green levies by the government and ‘network charges’ for investments in infrastructure. However, it is hard to see how, even taking into account all three of these possible sources of cost increases, the scale of price increases can be justified.

Another possible explanation for the price hikes is that they are partly the result of a system of transfer pricing (see). The energy industry is vertically integrated. Energy companies are not only retailers to customers, but also generators of electricity and wholesale shippers of gas. It is possible that, by the producing/shipping arms of these companies charging higher prices to their retailing arms, the retailers’ costs do indeed go up more than the wholesale market cost. The result, however, is higher profits for the producing arms of these businesses. In other words, a higher transfer price allows profits to be diverted from each company’s retailing arm to its producing arm.

This is an argument for making the wholesale market more competitive and for stopping the by-passing of this market by producing arms of companies selling directly to their retailing arms. What the companies are being accused of is an abuse of market power and possibly of colluding with each other, at least tacitly, to support the continuation of such a practice.

So is the answer a price freeze, as proposed by the Labour Party? Is it an investigation of the energy market by the Competition Commission? Or is it, at least as a first step, much more openness by the energy companies and transparency about their pricing practices? Or is it to encourage consumers to switch between energy companies, including the smaller ones, which at present account for less than 5% of energy supply? The videos, podcasts and articles consider these issues.

Why may the costs of energy paid by the energy retailers to energy producers/shippers have risen more than the wholesale price?

Explain what is meant by transfer pricing. How could transfer pricing be used to divert profits between the different divisions of a business?

How can transfer pricing be designed by multinational companies to help them minimise their tax bills?

Why is policing transfer pricing arrangements notoriously difficult?

What evidence is there to show that switching between retailers by customers can help to drive retail energy prices down?

How did the old electricity pool system differ from the current wholesale system?

Should electricity companies be forced to pool the electricity they generate and not sell it to themselves through bilateral deals?

Comment on the following: “The current electricity trading arrangements ‘create the very special incentive for the oligopolists. …The best of all possible worlds is where nobody invests. As supply and demand close up, the price spikes upwards, and supernormal profits result.’”

The UK electricity supply market is an oligopoly. Over 95% of the market is supplied by the ‘big six’: British Gas (Centrica), EDF Energy, E.ON, npower (RWE), Scottish Power (Iberdrola) and SSE. The big six also generate much of the electricity they supply; they are vertically integrated companies. Between them they generate nearly 80% of the country’s electricity. There are a further two large generators, Drax Power Limited and GDF Suez Energy UK, making the generation industry an oligopoly of eight key players.

Ofgem, the energy market regulator, has just published a report on the wholesale electricity market, arguing that it is insufficiently liquid. This, argues the report, acts as a barrier to entry to competitor suppliers. It thus proposes measures to increase liquidity and thereby increase effective competition. Liquidity, according to the report, is:

… the ability to quickly buy or sell a commodity without causing a significant change in its price and without incurring significant transaction costs. It is a key feature of a well-functioning market. A liquid market can also be thought of as a ‘deep’ market where there are a number of prices quoted at which firms are prepared to trade a product. This gives firms confidence that they can trade when needed and will not move the price substantially when they do so.

A liquid wholesale electricity market ensures that electricity products are available to trade, and that their prices are robust. These products and price signals are important for electricity generators and suppliers, who need to trade to manage their risks. Liquidity in the wholesale electricity mark et therefore supports competition in generation and supply, which has benefits for consumers in terms of downward pressure on bills, better service and greater choice.

So how can liquidity be increased? Ofgem is proposing that the big six publish prices for two years ahead at which they are contracting to purchase electricity from generators in long-term contracts. These bilateral deals with generators are often with their own company’s generating arm. Publishing prices in this way will allow smaller suppliers to be able to seek out market opportunities. The generating companies will not be allowed to refuse to contract to supply smaller companies at the prices they are being forced to publish.

In addition, Ofgem is proposing that generators would have to sell 20% of output in the open market instead of through bilateral deals. As it is, however, some 30% of output is currently auctioned on the wholesale spot market (i.e. the market for immediate use).

But it is pricing transparency plus small suppliers being able to gain access to longer-term contracts that are the two key elements of the proposed reform.

In February 2009, the world’s largest concert ticket agency, Ticketmaster, and the world’s largest concert promoter, Live Nation, announced that they intended to merge. The deal would have been worth around £550 million. This immediately sparked concerns that the new company would have such power in the market that ticket prices would rise. On 10 June 2009, the Office of Fair Trading, in line with the 2002 Enterprise Act, referred the proposed merger to the Competition Commission.

On 8 October 2009, the Competition Commission published its preliminary findings that “the creation of that situation may be expected to result in a substantial lessening of competition (SLC) in the UK market for the primary retailing of tickets for live music events”. The following articles look at the findings and the competition issues. You will also find links below to the Competition Commission press release and the Provisional Findings Report.

Cadbury is arguably the producer of the best Easter eggs and also one of the best known adverts – who can forget the guerrilla playing the drums! If you think there is no substitute for Cadbury chocolate, then you’ll find this story especially interesting.

In early September, Kraft Foods made a £10.2 billion bid for the maker of Dairy Milk. This was duly rejected by Cadbury, whose Chairman said that the offer ‘fundamentally undervalued’ the business. This initial bid, although rejected, has sparked interest in the corporate world and Cadbury shareholders have seen their shares rise in value by almost 40%, closing at 775.5p on Friday 11th September.

Following this bid, other potential buyers have entered the picture, including Nestlé and Hershey’s. There is also the likelihood that Kraft Foods will make a higher bid, financed through a bridging loan. Despite this interest, Cadbury still wants to remain independent, hoping that its investors will be buoyed by the company’s rising profits in recent months.

Take a look at the following articles that consider these possible take-overs of Cadbury and how the corporate world has been, and will continue to be, affected.

In the 13th September BBC News article, an extract from a letter to the Kraft Chief Executive from the Chairman of Cadbury stated that under Kraft’s offer “Cadbury would be absorbed into Kraft’s low growth, conglomerate business model, an unappealing prospect.” What does he mean by a ‘conglomerate business model?’

Eton Park has bought £180 million worth of shares. In what ways do you think this will affect the future of Cadbury? Is Cadbury more or less likely to sell now?

How would you explain the rise in Cadbury’s share price when it looked as though the company might be taken over?

Cadbury’s Chief Executive hopes that investors will continue to support the company given the positive profit margin growth. What does this actually mean?

If the take-over were to go ahead, what do you think would be the impact on the (a) the Cadbury factory in Birmingham; (b) Cadbury’s workers; (c) Cadbury’s shareholders; and (d) the price of Cadbury chocolate?